Monday, February 17, 2014

Maturity transformation is nonsense.

Mervyn King, recently retired governor of the Bank of England said in his "Bagehot to Basel" speech that "Maturity transformation brings economic benefits..” While I admire Mervyn King, his point about MT is simply a re-statement of a nonsensical element of the conventional wisdom. Also Paul Tucker(formerly a BoE official) believes in MT.

The truth is that MT is nonsense and for the following reasons.

MT enables banks to take numerous short term deposits and “transform” them into long term loans. Banks of course rely on the fact that while any given short term depositor is likely to withdraw their deposit at short notice, it is unlikely that ALL DEPOSITORS will do so.

Thus depositors can allegedly to some extend reap the benefits of instant access or near instant access to their money while benefiting from the decent interest rates that are to earned when granting a long term loan. And of course the relevant bank takes its cut.

But, and this is a big “but”, there is always a finite risk involved in MT. That is, it is always possible that too many depositors or other short term sources of funding for a bank disappear and/or withdraw their money: exactly what happened to Northern Rock and exactly what has happened to numerous banks throughout history.

So the risk is not just a theoretical one: it is VERY REAL. And how do we cover that risk? Well we have the taxpayer stand behind banks, or should I say “stand behind the whole charade”.

But that’s a subsidy of banks, and a cardinal and fundamental rule in economics is that subsidies misallocate resources (unless some very good justifications for a subsidy can be found). That is, wherever there is a subsidy for which there is no good reason, GDP is not being maximised.

So with a view to maximising GDP suppose we banned MT. That would raise the cost of mortgages and other loans, which would have a deflationary effect. Unemployment would rise.

But the latter undesirable effect would be easily countered by standard stimulatory measures, monetary or fiscal. Let’s say it’s done by the combination of monetary and fiscal measures favoured by MMTers and Positive Money, namely to simply have the state create new money and spend it into the economy (and/or cut taxes) in sufficient quantities to give us full employment.

The net effect of that would be that private sector entities (households and firms) would find it more difficult to borrow, but to compensate, they’d have a larger stock of cash: so they wouldn’t need to borrow so much!!!!!

Now would some advocate of MT like to tell us why the latter “more cash in your bank account and less borrowing” scenario is worse than the “lets allow MT and have everyone more in debt” scenario? The only way I can see of passing judgement on the two is the fact that allowing MT requires banks to be subsidised. Therefor that’s the inferior option. It’s the option that doesn’t maximise GDP.